Which Multiplier?

“I know the value of my business, it’s one and a half times sales,” said the business owner and was firmly convinced that any business appraisal would come to the same conclusion and thus, worthless.

However, in reality, applying a single multiplier is simply the worst mistake a business owner can do, in particular, if the selling of the business is the last step in monetizing many years of hard work in building the business.

Indeed, if only a single multiplier – such as sales in this example – is needed to establish a value of a business, then the world would be a very simple place.

But, if of two similar companies with the same sales level, one company were highly profitable, while the second is unprofitable, would buyers indeed value both companies the same by applying a multiplier to sales? Barely!

“Obviously, any savvy investor will look beyond a single multiplier valuation, indeed, most often, investors will look for cash flow being generated by the company as the most important criteria,“ says Achim Neumann, President, A Neumann & Associates, LLC, a New Jersey based Business Brokerage and M&A Advisory firm, helping mid-sized businesses to transfer business ownership.

So what are the “right” ratios to define a company’s value? Accredited, professional business valuation firms use a variety of different metrics in arriving at a Fair Market Value for a business – encompassing Balance Sheet and Profit & Loss data, as well as “real world” transaction closings:

Asset Based Business Valuation:

• Book Value Method
• Fair Market Value of Net Tangible Assets

Cash Flow Based Business Valuation:

• Single Period Capitalization Method
• Excess Earnings Method

Market Based Business Valuation:

• Historic Comparative Closings Based on Revenue
• Historic Comparative Closings Based on Seller Discretionary Cash Flow
• Historic Comparative Closings Based on EBITDA

Typically, a valuation firm first develops a market value based on each of these individual approaches, then weights each approach and uses the weighted average as the final Fair Market Value.

How does the valuation firm know the derived value represents the “right” value?

Generally speaking, the valuation firm will “test” the derived value against some plausibility checks. For example, a “Price Justification Chart” will be established to determine, if the derived value provides a realistic ROI for an investor. Further, a multiplier of EBITDA will indicate, if the derived value falls within the band with of previously closed transactions.

In short, a multitude of different metrics are being applied in arriving at a Fair Market Value for a company, and there is no such thing as one-multiplier defining a market value.

As a matter of fact, a single multiplier valuation is almost always wrong in defining the value of a business, and an incorrect value can be the reason for a business owner to leave “a lot of money on the table” (in case of an under-valuation), or to never sell the company while compromising confidentiality in the process (in case of an over-valuation).

And looking from an economic point of view, relying on a simple, one-multiplier valuation makes even less sense, given that the valuation expense is often less than 0.05% of a transaction – an amount, that can easily be re-cooperated in negotiations with a buyer by a well prepared owner with a properly valued business.

So, why rely on a single multiplier value determination and instead of having an accredited valuation in place?